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How to Price In Tax Reform: Market Recon

Just how excited should we be getting over the passage of that budget resolution last week? Just how excited should we get when the House Ways and Means Committee reveals their tax reform package as expected later this week? As for equities, small-caps (due to their higher effective tax rates) and the transports (due to increased prospects for growth that we may already be seeing) would be obvious beneficiaries, as would many of the big techs that might be enticed to bring home a portion of their cash currently held overseas in order to avoid paying high U.S. tax rates. Just for your information, the average effective tax rate for an S&P 500 company is currently about 28%; so, a drop in the basic corporate tax rate to 20% would even benefit many larger corporations. For those smaller companies that live in the Russell 2000, their effective tax rate is a lot closer to the advertised rate.

Tax reform is starting to get a mention in some earnings calls, but no firms that I know of have actually adjusted anything based on this. Still, it would be hard to argue that the recent gains made by both the Russell 2000 and the Dow Jones Transportation Index versus the S&P 500 are based on growth alone; more likely, in my opinion, on growth multiplied by expected growth. You saw last Wednesday's release for September durable goods orders, right? You understand the most important item within that report is core capital goods, correct? For years now, we have seen negative digits here, separated by spurts of minimal increases. What that means is that, other than payouts to shareholders, corporations were not investing in their businesses.

Now? Poof! Suddenly, a robust September result of 1.3% month-over-month growth that brought with it a revision to August that also brings that month's growth up to 1.3%. Year over year, September now can boast mighty 7.8% growth. After what we have been through, this is simply amazing. My point is that some folks, namely purchasing managers, are indeed starting to partially price in some kind of success on the legislative front. There is some belief across market participants that nothing is yet priced in, which I believe to be false. I will illustrate below. My thought? Successful tax reform keeps the trend intact. Failure provokes a medium-term change in the trend. Either result could produce a very short-term "sell the news" event.

Chart of the Day: Pricing in Tax Reform

In Chart number one, we use the S&P 500 as a baseline (black line). Representing the baseline as a constant, one can see that year to date, the Russell 2000 (red line) has under-performed the baseline by more than 4%, and the DJTA (blue line) has under-performed the same baseline by nearly 5.5%.

I think as most of you probably know that the S&P 500 is up more than 15% this year, while the Russell 2000 (up 11.2%), and the DJTA (up 9.8%) have lagged; this year-to-date chart above might not surprise.

This second chart may come as something of a surprise to the casual eye, or maybe to someone who does something else for a living, but tries to have a hand in determining their own financial destination. This chart still uses the S&P 500 as a baseline, but only covers the last two months.

Well, as you can now see, both of these "lesser" indices are outperforming the broader market over this timeframe. You can even see the reaction a few weeks ago to the ongoing headline risk that has made tax reform seem more or less likely over time, as other political headlines appear to take priority at times.

Sarge's Trading Levels

These are my levels to watch today for where I think that the S&P 500, and the Russell 2000 might either pause or turn.

SPX: 2606, 2593, 2582, 2574, 2565, 2559
RUT: 1527, 1521, 1511, 1506, 1500, 1493

Today's Earnings Highlights (Consensus EPS Expectations)

Before the Open: (CTB - Get Report) ($0.85), (DO - Get Report) ($0.20), (D - Get Report) ($1.02), (FDC - Get Report) ($0.40), (L - Get Report) ($0.19), (ROP - Get Report) ($2.29), (SRE - Get Report) ($1.05)

(This is an excerpt from Stephen "Sarge" Guilfoyle's Morning Recon, which now appears exclusively on Real Money, our premium site for active traders. Click here for a free 14-day trial and receive Morning Recon every day, along with exclusive columns from Jim Cramer, James "RevShark" DePorre, technical analyst Bruce Kamich and more.)

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